The Crude Facts About the Price of Oil

How dramatic are the price increases? What is causing prices to increase?

Global economies appear to be on their way to recovery from recent downturns. Even the Japanese economy, after a decade of recession and deflation, appears to be expanding. However, one possible potential problem looms on the horizon that could halt expansion and raise the specter of inflation: the price of oil.

Over the past months, headlines have almost daily recorded the ever increasing price of oil. Businesses and consumers around the world have watched as the price of oil approached $50 per barrel, fell back to $43, and now is surging toward $55 per barrel.

How dramatic are the price increases? What is causing prices to increase? These are the questions this article will address.

How Dramatic is the Increase?

Prices have increased—rapidly and unrelentingly. But how high are they? The price of a barrel of oil surged 38 percent from August 2003 to August 2004. Crude oil for current delivery on the New York Mercantile Exchange closed at $53.64 a barrel on October 13, 2004, far eclipsing the previous record of $41.15 set in October 1990. Crude oil had previously approached $40 a barrel in the early 1980s.

However, adjusted for inflation, prices are lower today than they were two decades ago. A barrel costing $40 in 1981 would cost almost $80 in today’s dollars.[1] Therefore, we must keep the price increase in perspective. Prices have jumped dramatically; they are hitting all-time records in nominal value, but if adjusted for inflation, they are below historical highs.

Why are Prices Increasing?

The most common cause of spikes in oil prices over the last 30 years has been a decrease (or threatened decrease) in supply. Prices increased during the Arab oil embargo in the 1970s, the collapse of the Iranian government and the subsequent war between Iran and Iraq in the 1980s, and the Iraqi invasion of Kuwait and subsequent war in the 1990s.

However, the cause of the high prices today is more complex. Members of the Organization of Petroleum Exporting Countries (OPEC) have discussed increasing their current target range of $21 to $28 a barrel partially as a reaction to the drop in the value of the dollar. Oil transactions are denominated mainly in dollars, so the depreciation of the dollar has substantially reduced the flow of funds into the coffers of oil producing countries.

Photo: Tammy Sharp

Nevertheless, prices are well above the target range and, with few exceptions, members of OPEC have been producing at full capacity for the last six months. The exceptions are Venezuela, Iraq, Nigeria, and Indonesia. Venezuela shut down oil production in December 2002 because of political turmoil and oil worker strikes. Although Venezuela is pumping again, some capacity has not yet been restored. Iraq stopped production at the beginning of the U.S. invasion in 2003, and though production has rebounded, exports still lag because of sabotage.[2] Oil worker strikes and ethnic violence have reduced production in Nigeria by 40 percent, and Indonesian production has declined because of a decrease in outside investment.[3]

If stability could be restored in these countries, OPEC could provide limited relief, at least in the short-run. However, other oil producing countries may be the key to supply in the long-run. Russia has been expected to emerge as a major oil supplier. Production increased by 48 percent in the last five years with the development of new fields and new pipelines, but confidence in the stability of Russian oil has been shaken by events at Yukos, the largest Russian oil company. The Russian government has demanded billions of dollars in back taxes, imprisoned Yukos’ founder, and frozen the company’s bank accounts. If the problems in Russia are solved and other countries such as Mexico and Canada increase their production, experts believe that non-OPEC countries could increase production by 20 million barrels per day by the end of the decade.

If constrained supply is not the main or sole culprit of price increases, what is? We will discuss three factors: demand, speculation, and refinery capacity.

The Demand Goes Up and Up!

As economic activity increases, the demand for oil increases. Nevertheless, the magnitude of the increase has taken many by surprise. The International Energy Agency (IEA) recently revised its demand growth estimate for the second quarter to 78.3 million barrels per day, which is 2.2 million barrels per day above that of 2003.[4] Increased demand has been particularly high in the U.S. and China.

In the U.S., the greatest increase has been in the demand for gasoline. American drivers use 45 percent of the gasoline consumed globally. The second biggest gas-guzzler, Japan, consumes only 5 percent of the world’s total.[5] From mid-April to mid-May 2004, U.S. gasoline demand averaged 9.1 million barrels per day—an increase of 3.2 percent over the previous year.[6]

The magnitude of China’s demand has propelled energy prices, with the Chinese economy responsible for one-third of the rise in daily global oil consumption. China’s increasing affluence has caused automobile sales and air travel to surge. The country’s rapid industrialization has placed strains on its infrastructure, including its ability to generate power.

China has invested in energy intensive industries such as steel, aluminum, and plastics, which uses inputs derived from crude oil. The combination of increased car ownership and industrialization has doubled Chinese oil consumption in the last ten years. Increased oil consumption has caused China to pass Japan as the second largest oil consumer, following only the U.S.[7]

Speculators Move In

The New York Mercantile Exchange began trading crude oil futures in 1983. The volume and open interest—the number of contracts outstanding—have increased rapidly. The average monthly volume of contracts traded averaged over 3.7 million in 2003 compared to approximately 37,000 in 1983.

Energy futures allow large consumers of oil and natural gas to hedge against adverse price movements. In addition, energy futures provide valuable tools for constructing cross-hedges—hedging against adverse price movements in a commodity for which there are no futures contracts with contracts of a different commodity.

However, speculative investors seem to be active in the energy futures market. First, it appears that the volume of trading in oil futures is above that expected for hedging purposes alone. Second, large risk premiums seem to be added to these contracts due to terrorist activities. We will examine both of these observations.

Several methods are available for estimating the impact of speculative influences on energy prices. One method examines the net position between those who buy on the long side—the camp that expects prices to continue to rise—and those who buy on the short side—investors who expect prices to fall. If we observe a positive net position, then speculative interest is creating a bubble that produces a premium in the price of oil. Net position fell from its peak in March, an indication that fewer people now think prices will continue rising and that speculative activity is decreasing. However, the current level is still double that of 2003, a record at the time.[8]

A second method is to examine trading volume and open interests. Figure 1 contrasts “trading volume” with “open interests.” From 1983 to 2000, trading volume normally averaged below total open interest, thereby reflecting reasonable demand for energy hedging instruments. Exceptions can be noted, particularly from 1988 to 1990, the time preceding the first Gulf War. Since late 2000, however, a new dimension has been seen in crude oil futures. Perhaps traders, no longer viewing equities as an attractive trading medium, have switched their focus. For whatever reason, contract volume has increased and now, at times, far exceeds open interest, a sign of speculative activity or of demand exceeding supply.

The large spike in contract oil volume in 1990 undoubtedly stemmed from uncertainty over the supply of oil. The same scenario can be seen today with the increase in terrorist activity throughout the Middle East. Increased trading in oil futures may be related to increased uncertainty in the supply of oil. On the other hand, uncertainty creates volatility and market inefficiencies, volatility creates short-term profit opportunities, and short-term profit opportunities attract speculators.

Uncertainty also increases the risk premium added to the price of oil futures contracts. Iraq’s oil fields, pipelines, and export terminals are a favorite target of insurgents. Attacks on the main oil export terminal at Basra have increased concern about future supplies and doubled insurance costs for tankers going to Basra, thereby causing oil prices to increase.[9] Exports fell by one million barrels per day after the southern pipeline was bombed, almost wiping out production increases from OPEC.[10]

As crippling as the attacks in Iraq have been, attacks in Saudi Arabia have been more devastating. After a series of raids on suspected terrorist safe houses that thwarted several planned attacks, Saudi luck ran out. Since May 2004, attacks on foreign workers’ housing and kidnappings of foreign workers have occurred. These attacks have led to the withdrawal of foreign workers by several firms and the threat of removal of workers by other companies. The loss, even temporarily, of a large number of foreign oil workers could cripple Saudi production.[11] These events have added to the fears that oil flow will be disrupted and have added pressure for oil prices to rise.

Limited Refinery Capacity

Demand and speculation have increased the price per barrel of crude oil, but the price of gasoline has increased by a larger percentage. This additional increase may be explained by limited refinery capacity and structural problems.

The IEA estimates global refinery capacity at 81.2 million barrels per day, which is about two million barrels per day above current consumption. However, refinery capacity is below IEA estimates for fourth quarter consumption of 82.4 million barrels per day.

The number of refineries in the U.S. has decreased by about two-thirds in the last twenty years to approximately 150 plants. Total production capacity has decreased from 19.78 million barrels per day in 1990 to 17.68 today. Low profit margins in the 1990s caused the closure of many small refineries. Because of reduced capacity and increasing demand, U.S. refineries are operating at 96 percent capacity.[12]

No new refineries are planned in the U.S. or Europe because of tighter environmental standards. However, current high profit margins are stimulating proposals for increased refinery capacity in Asia, where environmental standards are lax. While the U.S. imports only 13 percent of its domestic gasoline requirements today, experts suggest that in the future, crude oil will be shipped from the Middle East to refineries in Asia with the final product then shipped to the U.S.[13]

In addition to reduced capacity, U.S. refineries face stronger environmental standards. Refineries have been upgrading plants, prolonging the times they close for maintenance, and reducing their production.[14] Unfortunately, many foreign refineries have not upgraded. Gasoline imports fell 20 percent in April 2004 as compared to April 2003, thereby putting a further strain on U.S. refineries.

Beyond capacity and environmental issues, domestic structural problems also impact the distribution of gasoline. Emissions standards differ from state to state. Therefore, gasoline blends vary from state to state. This variability makes it difficult to move excess gasoline capacity from one state to another and increases the overall price of gasoline.[15]

Conclusion

What does it all mean? On the supply side, political stability in OPEC countries could provide some relief in the short-run. However, the world may have to look to non-OPEC countries for long-term relief. The recent spike in oil prices caused primarily by hurricane damage to Gulf of Mexico wells demonstrates the ongoing concern over stable supply.

Photo: Alvaro del Canto

On the demand side, Americans have not decreased the amount they drive. However, recent vehicle sales suggest a shift from gas-guzzling SUVs to hybrids and other fuel efficient automobiles. It is too early to say whether this is a real change or a temporary phase; sales will be closely watched to see if the pattern persists.

Other oil consumers may also be reducing their demand. China has announced plans to generate 10 percent of its power through renewable sources by 2010. China’s ambitious plan depends mainly on small-scale hydroelectric projects.

Oil refinery capacity will continue to be a problem. No new refineries are planned in the U.S. or Europe. U.S. refineries have pledged to produce at full capacity and minimize downtime for maintenance, but an increase in refinery capacity is needed to meet demand.

Speculation seems to be increasing. Speculators and institutional investors appear to be turning to oil to provide financial returns lacking in the current bond and equity markets. In addition, uncertainty is high as violence in Iraq and Saudi Arabia continues.

Energy prices are a continuing concern to world economies. If oil prices do continue to increase, the rate of recovery of world economies may be slowed. With uncertainty high, and if additional events occur that disrupt the flow of oil, then be prepared—the worst may be still to come.

About the Author(s)

Peggy J. Crawford, PhD, joined the faculty of Pepperdine's Graziadio School in 1997 after serving on the faculties of the University of Houston, Fordham University, and George Mason University. She has published in a variety of journals on topics such as leasing, mortgages, closed-in mutual funds, the depreciation of the dollar, the trade and federal deficits, and the price of oil. She has served as a consultant for such firms as Sprint, AT&T, various state CPA societies, and the Washington Redskins (her favorite client!).